What is energy efficiency finance? What are the common financing mechanisms? In this article, Urban Data Lab’s collaborator Yang Zhou will share his thoughts on energy efficiency finance.
Improving energy efficiency in the built environment is an essential part of Canada’s strategy to cope with the issue of climate change, which calls for large-scale investments in energy efficiency improvements in the built environment over the next decade. Energy efficiency finance can be a critical tool to support this cause. As Canada moves to meet its long-term GHG reduction scheme and net-zero emission target, higher energy efficiency standards need to be properly enacted and effectively implemented. A well-functioning and supportive energy efficiency finance market will help to build large-scale market uptake of these energy efficiency measures and facilitate this strategic transition.
Additionally, with a low-interest rate prospective in the post-COVID era, the investment community is also looking for new directions and opportunities, and energy efficiency investments can be an attractive option. The economic slowdown experienced by Canada during the COVID pandemic and the urgent need for a green and speedy recovery also provide an incentive to support innovative financing mechanisms for energy efficiency activities, as these would help stimulate economic growth and job creation.
To accomplish this transformation, a vibrant energy efficiency finance market needs to be established in a timely manner to support all kinds of energy efficiency activities. According to the categorization of UNEP Sustainable Energy Finance Initiative (SEFI) and Basel Agency for Sustainable Energy (BASE), there are three types of energy efficiency activity that need financing: technology innovation, energy efficiency ventures, and energy efficiency projects (BASE, 2006). Financing activities relevant to different types of energy efficiency activities constitute different segments of the energy efficiency finance market (see Exhibit-1).
Technology Innovation Finance
Technology innovation is the process of introducing a new or improved energy efficiency technology, product, or business model whose technological characteristics are significantly different from the incumbents in the market. It consists of three major stages, which are Research and Development (R&D), Demonstration, and Commercialization. Different stages of technology innovation require the support from different types of financing mechanisms. But overall, due to its pre-commercialization character and high-risk nature, technology innovation is mostly funded by public financing approaches, such as grants, tax incentives, or soft loans. It may also be funded by investors with high-risk tolerance such as angle investors or early-stage venture capitalists, by means of equity financing.
Energy Efficiency Venture Finance
Energy efficiency ventures are businesses that produce, market, distribute, and sell energy efficiency products and services. The former includes companies that produce and deliver energy efficiency equipment and appliances, building construction and retrofit materials, consumption metering and intelligent control systems, etc. The latter involves companies that provide energy efficiency consultation, energy retrofit service, and energy performance management, etc. Like firms in other business sectors, energy efficiency ventures need capital to support their daily operation and business development. They normally obtain financing via traditional mechanisms such as commercial loans, leasing, or equity financing. Among all actors in the market, energy service companies (ESCO)have drawn much attention during the last decade, largely due to its role as a market enabler and its high impact on the growth of energy efficiency sector.
Energy Efficiency Project Finance
Energy efficiency projects are capital expenditure activities that reduce energy consumption and increase energy efficiency for the end users (the subject buildings in a project). Those projects usually entail green building construction, energy efficiency building retrofits, and complementary renewable energy installation. The cost of the project is recovered from the energy savings derived from the energy efficiency improvement.
Project finance may be needed to cover the expenses for energy audits, energy advisory services, energy efficiency equipment, installation, and monitoring. The goal of project finance is to provide energy efficiency project operators, such as building developers or homeowners, with a cost-effective alternative to spending their own money on the energy efficiency improvements. Essentially, most energy efficiency finance structures aim to bring project operators an access to up-front capital for the energy efficiency projects, which are then repaid over time via energy savings generated in the future. The chart below illustrates the basic structure of energy efficiency project finance (see Exhibit-2).
The energy efficiency project finance market can be further divided into three segments on the basis of the end user of a subject building, which include:
- Residential Buildings
Residential buildings are real estates zoned specifically for living or dwelling for individuals or households rather than business entities. Residential buildings can be standalone single-family homes, townhouses, condominium units, multi-unit apartments, and so on. In this market segment, traditional financing sources, such as personal term loans, line of credit, and home equity loans are the primary means for financing energy retrofit projects. In addition, utility or public funded grants and rebates are also being used to finance small-scale and ordinary energy efficiency measures (such as LED lighting, energy efficient water heater, building insulation, etc.). New and innovative models for financing energy efficiency are beginning to emerge, including Property Assessed Clean Energy (PACE) and On-Bill Finance (OBF).
- Commercial and Industrial Buildings
Commercial and industrial buildings are real estates zoned for generating profit. Commercial buildings include workplaces, offices, stores, or other distinctive structures used in and for businesses, or commerce. Industrial buildings are generally factory or warehouse buildings, where products are made or stored for industrial purpose. While this market segment encompasses different kinds of property, these end-users often have similar economic objectives from a financing perspective (Wilson Sonsini Goodrich & Rosati, 2012). Possible financing mechanisms in this sector include traditional bank loans, corporate bonds, Energy Performance Contract (EPC) or Energy Service Agreement (ESA) financing, lease financing, PACE financing, and on-bill utility financing.
- Institutional Buildings
Institutional buildings are property developed as governmental, educational, health, cultural and recreational centers, places of worship, and cemeteries, etc. These buildings are generally owned and operated by government entities or by non-profit organizations. This market segment has access to a wide range of energy efficiency finance options, such as government bonds, loans, lease financing, and EPC or ESA financing models.
To attract more public and private investments to the building energy efficiency market, appropriate financing strategies and mechanisms are needed for various market sectors and different energy efficiency activities. The goal is to bring affordable and accessible financing to market actors and deliver profitable investment opportunities to financial institutions and investors.
Energy Efficiency Financial Instruments
Today, various private and public financial mechanisms for green building development and building energy retrofits are available in Canada and other jurisdictions. These mechanisms may take the form of non-repayable incentives, debt financing, equity financing, credit enhancement, or a combination of different modes. Eligible financial instruments for financing energy efficiency projects range from traditional methods such as grants and loans to emerging models such as on-bill finance and energy performance contracts (EPC), and to very innovative and not yet well tested models in the Canadian market such as energy efficiency mortgages, Property Assessment Clean Energy (PACE), and crowdfunding. The figure below (see Exhibit-3) illustrates different financial instruments in terms of their category of mechanism (non-repayable incentives, debt financing, equity financing, and credit enhancement) as well as penetration level in the Canadian market (traditional, emerging, and innovative).
There is not a “silver bullet” that suits all energy efficiency projects. Instead, different energy efficiency financing models have their pros and cons and have been developed to address the specific needs of different kinds of projects. The suitability of a particular financial instrument often depends on a combination of factors, including project type (e.g. new building development or existing building retrofit), project size, expected return, anticipated payback period, investor risk profile, and security requirements, etc.
Basel Agency For Sustainable Energy (Base), Public Finance Mechanisms to Increase Investment in Energy Efficiency: A Report for Policymakers and Public Finance Agencies, 2006
Wilson Sonsini Goodrich & Rosati, Innovations and Opportunities in Energy Efficiency Finance, May 2012 Second Edition
UBC Sauder Center for Social Innovation & Impact Investing
Yang Zhou is a researcher at UBC Sauder Centre for Social Innovation & Impact Investing (Sauder S3i). He works on impact investing research and consulting projects with impact funds, investors, social entrepreneurs & ventures, charitable organizations, and financial institutions. Yang’s current focused areas include urban development and sustainability, renewable energy, energy-efficient building retrofits, sustainable and climate-resilient agriculture, and other social finance and impact investing themes.